10-year Treasury yield hit 2.58% record low. Is it a flight to quality or a Treasury Bubble?

That's right! 10-year Treasury yield has hit a new low of 2.58% today. This low level is virtually unheard of since early 2009.

So, is it a flight to quality, or a bubble in Treasury bonds? Or a consequence of the FOMC signaling QE2 program to keep monetary easing in place, with close to zero rates for an extended period of time.

To me, this Treasury rally sooner or later will run its course. Investors who fear deflation risks are parking their money in Treasuries in the present uncertain economic outlook. They may get burned if the recovery is sustainable and yields eventually rise. However, investors are preferring to suffer from small losses on Treasury holdings rather than sustaining huge losses in stocks and risky assets if economic outlook deteriorates or the Fed is unable to steer the economy. This risk aversion is known as Prospect Theory, which underlies much of behavioral finance.

The new year euphoria is still on -- but Pimco has fired the first warning salvo

Everyone is looking forward to a roaring first quarter of 2010, but a few days ago, Bill Gross of Pimco has fired the first warning salvo on US and UK debts. The markets barely registered the news as everyone is focusing on how great the first quarter results would be.

Pimco is reducing the holdings of both US and UK because their governments increased borrowings to record levels. Furthermore, Pimco is cautious on corporate bonds and mortgage-backed securities. As the economy recovers, the inflation expectations are going to be leaning on the high side. As a result, the Fed would be under the gun to perform the appropriate action, i.e. increase Fed rates. But in reality, the Fed is not inclined to do so because unemployment is still stuck in a rut. However, long-term 10-year Treasury yields have already increased to approach 4%. Outstanding U.S. public debt has climbed 58 percent to $7.175 trillion as of November from $4.537 trillion in December 2007 as the government has borrowed to fund two stimulus programs and fund record budget deficits. The U.S. budget deficit reached $1.4 trillion for fiscal 2009.

According to Bill, investors will face lower than average returns coupled with heightened government regulation and scrutiny and slower economic growth.

Pimco's money managers favor sovereign debt, corporate bonds and currencies in emerging markets. Bill also likes Germany, where the government is more fiscally conservative as it pledges to balance its budget by 2016.

This serves as a wake-up call for the US, UK and particularly Japan because 2010 would not be any easier on the government finances as in 2009. Quantitative easing and stimulus measures are only effective up to a point, and should be withdrawn appropriately after.